Can the Fed Turn the Market Around?

04/17/2014 12:00 am EST

Focus: GLOBAL

Jim Jubak

Founder and Editor, JubakPicks.com

MoneyShow's Jim Jubak wants to wait and see how the market reacts to Yellen's announcement yesterday that the economy continues to operate with higher unemployment and lower inflation, two major gaps that could take years to close.

Did the Federal Reserve ride to the market’s rescue Wednesday?

I’ll still want to see how the market reacts over the next few days but, at worst, Fed chair Janet Yellen shifted the risk/reward odds massively on April 16, and, at best, she put an end to the recent market downturn that took the NASDAQ down near true correction territory of a 10% drop and that pushed the biotech sector into its own 20% bear market.

In her speech on Wednesday, Yellen said that the economy continues to operate with two major gaps, even after staging a slow, but significant, recovery. Unemployment is still substantially higher than what economists call full employment, and inflation is still stubbornly lower than the Fed’s 2% target. The full employment rate calculation now results in an unemployment rate of 5.5%. (And yes, it is confusing that, at the full employment rate, the unemployment rate is still 5.5%. Economists calculate this number using all kind of assumptions about how low the unemployment rate could be before driving up inflation, to an unacceptable level given bottlenecks and inefficiencies in the current structure of the economy.)

It could take as long as two years to close those gaps, Yellen said on Wednesday. And, therefore, it could be two years before the Federal Reserve starts to raise short-term interest rates from their current 0% to 0.25% range.

This formulation of the Fed’s operating parameters is an extension of what the policy debated in the March 19 meeting of the Fed’s Open Market Committee. In the minutes of that meeting, released on April 9, the Fed abandoned its former target of holding short-term rates near 0% until the official unemployment rate hit 6.5%.

In recent months, that target has become increasing problematic for the Fed and increasingly troubling to the financial markets. The official unemployment rate has been slowly creeping downward until it now stands at 6.7%—but the decline has been accomplished without a significant improvement in the number of people working. In most months showing a drop in the rate, the decline has been a result of discouraged workers leaving the workforce and a fall in the labor participation rate.

With the unemployment rate dropping, but the economy not showing a corresponding improvement, the Fed, in its March meeting, said that it would move to a vaguely defined goal of reduced unemployment and higher inflation. That goal was so vague that it left the financial markets scrambling to translate it into an actual policy calendar. Initial fears that the Fed could be thinking of raising rates as early as the first quarter of 2015 never quite went away even as the consensus moved toward a belief in a mid-2015 date for possible action.

Yesterday’s statement from Yellen was such a potentially big deal for financial markets because it stretches out that calendar again. By moving the target rate from the former 6.5% unemployment rate to 5.5% rate, Yellen set the Fed a task that could well take two years. And certainly, the refusal of the inflation rate to move to 2%, even with the Fed pumping $85 billion a month into the financial system through its asset purchases, isn’t going to present any less of a difficulty now that the Fed has started to taper off its month asset purchases.

Much of this very long bull rally—it turned five years old in March—has been built on cash flows from the Federal Reserve, the European Central Bank, the Bank of Japan, and the People’s Bank. The stumble in 2014—it isn’t any more serious than that, so far, for the S&P 500—has been in major part on worry that the Fed’s taper of asset purchases was a prelude to an increase in short-term rates from 0% in early 2015.

That timetable now looks completely outdated. If indeed it took two years to reach the Fed’s unemployment and inflation goals, then markets aren’t looking for an interest rate increase until April 2016.

With the rising hopes that the People’s Bank will have to stimulate the Chinese economy soon (I say June or July), with statements from Mario Draghi that put some kind of stimulus from the European Central Bank on the table, with the Bank of Japan promising Prime Minister Abe that it won’t let the progress on inflation and economic growth slip away, Wednesday’s talk from Yellen could mark a turn in market psychology, away from worries about when the central bank will tighten, to speculation on when they might stimulate (or, in the Fed’s case, how long it will stay in a loose monetary mode).

I think “Don’t fight the Fed” is back in force. I’d like to watch the market action for a few days before making too many buys, to take advantage of some of the lower prices created in the last weeks. But I’d be willing to nibble now on the basis of Yellen’s speech.

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